Long ago and far away I taught economic principles and money and banking in night school. Since those three-hour classes came after long hours in my day job, I must admit—against interest as the lawyers say—that I tended to emphasize things that were easier to teach. Nothing was easier than simple Keynesian relationships because of the precision of their arithmetic.
You could stack an investment line and later a government spending line on top of a consumption line and establish equilibrium spending and income by the intersection of the top line with the 45-degree line. Or, you could subtract the consumption line from the 45-degree line and get a saving line that you could plot against the investment line to get the same equilibrium levels. You could compute a multiplier, which was simply the reciprocal of one minus the marginal propensity to consume, or, even more simply, the reciprocal of the marginal propensity to save. And so on.
It was easier to remember these mechanical relationships than it was to remember relevant economic history. Furthermore, if the students had read the history chapter that afternoon, chances are they would recall it better than I did, not having a chance to review it before class. Hence, the emphasis on the easy-to-remember stuff.
I’m reminded of all this by the current debate over whether the Bush tax-rate cuts should be renewed across the board or only for those with incomes below $200,000. We hear over and over that “the rich” have a lower marginal propensity to consume and, thus, smaller multipliers than the multipliers of real people, or no multiplier at all. This is supposed to justify raising taxes on the rich.
Leaving aside whether $200,000 makes one rich and leaving aside that the Keynesian multiplier concept applied economy-wide rather that to the individual, such a conclusion is, as they say, fatally flawed. It is flawed mainly because it confuses saving with hoarding and assumes that income not spent in the first round on consumption is not spent at all, even in subsequent rounds. I only hope my classes didn’t contribute to this confusion, which was the principle theme and flaw of the “under-consumption” theories held by Keynes’ intellectual predecessors.
While lower income people probably do spend a larger percentage of their marginal income on consumption in the short run, the income of higher income people usually gets spent, either directly on physical investment or indirectly on investment after financial intermediation. Buying stocks or bonds or depositing income in a bank or other financial intermediary doesn’t mean money not spent. It just means money not spent in the first round on consumption. It is usually spent in later rounds on investment.
If the marginal propensity to consume were 100 percent, there would be no investment, and, soon, no income.